Monday, September 26, 2011

The Reasons Behind the Overbuilding of Luxury Retail Malls in China

Some readers may have mistakenly ascribed a political agenda to my postings about Chinese real estate. My views on commercial real estate are nonpartisan and non-ideological.

To those who think that I have been poking fun at “The Communists” or the Chinese government, I point out that the fiascos I've reported have been capitalistic decisions of private owners and investors which happen to have occurred on Chinese soil. (Only one, New South China Mall, had some government involvement, as it was financed by the Agricultural Bank of China, which was State-owned at the time of funding nine years ago.)

I even disagree with the notion that the People’s Republic of China is a communist society. During my trips to the PRC I’ve met many Chinese people, none who have ever expressed the sentiment that he or she wanted to create a classless, utopian society that benefited “The People” rather than themselves. Most just tell me “I want to be rich”. If I ask for an opinion of Chairman Mao, I generally get a strange look which implicitly asks “What century are you living in?

As part of enforced “general education” requirements as an undergraduate at the University of Chicago, I was required to read The Communist Manifesto and The Russian Revolution (strictly in the context of critical inquiry), and neither Karl Marx nor Lenin ever stated that “The People shall have an Omega watch store every four blocks.” or "From each, according to his abilities; to each, a Gucci handbag." Overbuilding is not a Marxist concept, but Marx did explain in Das Kapital that overproduction is part of the natural outcome of a capitalistic society.

Karl Marx has probably caused more human suffering than any other philosopher who ever lived, but his criticism of capitalism was often insightful. He explained that technological advances increase labor productivity, which increases material wealth in the ruling classes while diminishing wages of workers, creating “poverty in the midst of plenty” manifested by overproduction and underconsumption. That may just be what is ailing China at the moment, as Chinese consumer spending as a proportion of GDP has been declining for the last half century in China.

Article in October issue of Shopping Centers Today

Next month’s issue of Shopping Centers Today (the house publication of the International Council of Shopping Centers) quotes me among other analysts in an article entitled “Many shiny new malls in Asia are devoid of tenants and shoppers”. Curt Hazlett reports many new but empty luxury malls in both China and India. There are various reasons cited, chiefly lack of experience and market analysis by the actual developers, who are private entrepreneurs.

This misallocation of resources is now being discouraged by the Chinese government. Recently, the Chinese Banking Regulatory Commission has been trying to proactively engineer a soft landing to a real estate bubble through stricter bank regulations. Reckless Chinese developers now find themselves unable to get Chinese bank loans for ill-conceived projects. The People’s Bank of China reports, for instance, that new lending to property developers declined to 42 billion yuan ($6.56 billion USD) in the second quarter of 2011, down 75% from 168 billion yuan in the first quarter. I have also seen similar policies put in place by the elected governments of Singapore and Hong Kong.

Real estate developers the world over are like heroin addicts, constantly seeking financing, and Chinese developers are no exception. If you give enough money to a developer, he will develop, because that is his raison d’etre. Chinese developers have found two alternate sources of funding after the shutting off of the Chinese banking spigot: private trust companies within China, which funnel investments from wealthy individuals and companies, and REITs created on foreign stock exchanges. The Chinese government is now cracking down on trust company lending, too.

So what is currently causing the continued overbuilding of luxury malls in China? In short, it is foreign investment. The “Chinese economic miracle” has been oversold to naïve foreign investors by self-serving capitalists. If the focus is on wealthy Chinese, most of their shopping is done outside the country, particularly in Hong Kong, in order to escape the VAT, the customs duty tax and the consumption tax, together adding up to as high as 60% on imported goods. That is why all the Hong Kong malls are full.

This last year has shown that it is easier to finance grandiose Chinese commercial real estate development schemes with equity offerings on foreign exchanges than with Chinese lenders. These equity investors (shareholders) have often been suckered because the "Chinese economic miracle" story has been so compelling and the IPO sponsors have been less than forthright. The logic that Chinese GDP growth is causing equivalent growth in consumer demand is contradicted by actual statistics: Per ISI Emerging Markets Inc., who maintains the CEIC China Premium Database, Chinese consumer spending as a proportion of GDP has now hit an all-time low of 34% and predicted to decline for two more years after being about 45% one decade ago and about 50% two decades ago, not quite the "consumption revolution" crowed about on empty New South China Mall's web site.

Walking through empty retail malls in Dongguan, Beijing and Shenyang, I was struck by the high prices on the merchandise offered. The median household income for Class-1 and Class-2 cities is estimated to be about $5700 per year, about 12% of the U.S. median, which is not conducive to a Gucci lifestyle. (The Chinese national average is about $3300 per year.) Wealthy Chinese, however, have the ability to travel and shop outside the country, where they find lower prices on luxury items, whether in Hong Kong, Singapore, Beverly Hills, or Vancouver. (Hong Kong attracts many Chinese shoppers due to the lack of a sales or value-added tax.) That narrows down the universe who have the resources and desire to buy their luxury goods domestically.

Recruiting foreign investors

Foreign investors may have misconceptions about Chinese shoppers based on the Chinese shoppers who travel to their own countries. These shoppers represent the affluent class of China, which is small in proportion to the total population. Mall investment sponsors have been capitalizing on this misconception.

Foreign investors are easier to take advantage of than Chinese investors due to their lack of legal recourse when they are cheated. Law enforcement can be heavy-handed within China. For instance, while I was staying in Shenzhen, the former mayor had just been convicted of corruption and sentenced to death. Executives of a company committing fraud on the Shenzhen or Shanghai stock exchanges are subject to severe criminal penalties, particularly if they cheat the government. Not so if the company is listed on a foreign exchange, such as Hong Kong, Singapore, New York or Toronto.


Just as U.S. securities laws are not extra-territorial, neither are Chinese securities laws. China does not have GAAP (Generally Accepted Accounting Principles), so the rules governing accounting are different; Chinese accounting policy has been nicknamed CRAAP (Chinese Regularly Accepted Accounting Policy) by hedge fund manager Jim Chanos.

The Chinese economic miracle has been a 30-year growth trajectory that has averaged annual GDP growth of 10% per year (according to the government) and created 115 billionaires as of the last Forbes count. Just remember, though, that the building of empty malls and office buildings is part of that GDP growth.

Chinese consumer spending has failed to keep pace, too, as Chinese household income, is less than 10% of U.S. household income. This is what Marx predicted would happen to capitalist societies, that workers would end up being financially unable to buy the very products they were producing. The empty luxury malls are evidence of that.

Tuesday, September 20, 2011

A Visit to Perennial China Retail Trust’s Assets in Shenyang, China 鹏瑞利中国零售信托

Recapping my June post on Perennial China Retail Trust (PCRT), PCRT was a recent Chinese real estate IPO on the Singapore exchange which advertised itself as the only “pure play on Chinese retail” available to Singaporean investors. It advertised “a total valuation of approximately S$1.1 billion as of December 31, 2010” based on an "independent valuation" of its five principal assets, which are two malls and an office complex situated together in Shenyang and malls in Foshan and Chengdu, but the valuation report was based on the false premise that all five properties had been completed and fully leased, when only one building, the Red Star Macalline Furniture Mall, had been completed and opened, and the malls in Foshan and Chengdu had not only not been started, but the land had not yet been acquired by PCRT at that time. In other words, the Foshan and Chengdu malls did not exist, yet they had been included in the current market valuation of this trust, as published on page 434 of the Prospectus.

In other words, the valuer had not been independent and had instead abetted the misrepresentations of the IPO sponsor. It should also be noted that the CEO/IPO sponsor receives substantial annual compensation (0.38% of appraised value) based on the independent valuation rather than the market capitalization of the outstanding shares, which is now less than half the amount of the "independent valuation" report. This is another built-in conflict of interest within PCRT.

I also questioned why the Singapore Exchange would allow PCRT to represent undeveloped properties as being fully developed and leased in their representations to the public of total asset valuation and why there were no controls on the misbehavior of supposedly “independent valuers” who are in reality the paid advocates of IPO sponsors.

PCRT initially attempted to go public in February by offering approximately 1.1 billion shares at S$1 per share but received an inadequate response. The offering was re-priced at S70 cents per share in June and was fully subscribed at that time. Since then, the market-traded share price has declined to S40 cents per share as of October 5, 2011. With 1,121,695,000 shares outstanding, this represents a loss to investors of more than S$336 million in market capitalization.

The visit to Shenyang

The location of the Shenyang properties is highly visible and accessible via the First Ring Road, and the Longemont Mall also has its own bus depot and subway rail station. This is a first-rate location.

I was disappointed to find the renamed Red Star Macalline Global Home Furniture Life Mall closed for the day at the time of my arrival at 7:15 pm. I naively assumed that it would be open late like most Chinese malls, but its official closing time is 6:30 pm; the error was mine. The closing time is the same at the other Red Star Macalline store in Shenyang.

The Longemont Shopping Mall had its opening on July 1st and is a beautiful sight to behold. The only things lacking are tenants and shoppers and western-style toilets. (Chinese "squat" toilets are simply porcelain holes in the floor. For a purposely western-style mall, this is an incongruity that I just cannot take sitting down.)

Ground floor of mall, 7:15 pm on a Friday evening

First floor of atrium

Third floor

To be fair, basement levels B1 and B2 have a hubbub of activity drawn by a major 20,000 square meter (215,000 square foot) supermarket with linkages to the city’s bus and rapid transit systems. Floors 1 through 7 were a different matter entirely, as seen in the other photos. My visit was timed between 7:15 and 8:30 pm on a Friday evening.
Basement supermarket

Many multi-level Asian malls also have their top floor or floors devoted exclusively to restaurants, and this can be one of the busiest sections of a mall in the evening. Not so here. Longemont’s 7th floor is also devoted to restaurants, plus an ice skating rink, but it appears that only half of the restaurant space has been rented out.
Seventh floor restaurant level

While I was dining on shredded dog meat in chili sauce on the 7th floor, I asked an employee why the Red Star Furniture mall was closed so early, and he was surprised to hear that it was already closed for the day, claiming that it was supposed to be open until 9 pm just like the Longemont Mall. “Not many people go there,” he also said. Nevertheless, the signs at Red Star Mall clearly indicate a 6:30 pm closing time.

Miscount of tenants at Longemont Shopping Mall

Although the PCRT web site advertises Longemont Mall as having 800 tenants, the number of open stores appears to be less than 200.

Is Longemont Shopping Mall "skating on thin ice"?

Two 56-story office towers are still under construction and show progress compared to previous photos from June. Leasing activity is not known yet.

Options on other sites next to future High Speed Chinese Rail Stations are also mentioned in the Prospectus. The July 23rd high speed train crash in Zhejiang that killed 40 and injured almost 200 revealed shoddy standards and official corruption which warranted the the arrest of the former railway minister Liu Zhijun. As a consequence, railway construction is now being delayed, with only one-third of projects still ongoing construction, while many railway construction workers complain about not being paid (more than 2000 alone at the China Railway Engineering Corporation.) What is the consequence for PCRT assets located at future high speed rail locations?

Remember, too, that all 5 properties are situated on ground leases. The Shenyang lease expires in year 2059, while the Foshan and Chengdu leases expire ten years earlier. What will happen then? The Chinese ground lease system only started in 1980, so none have expired yet, and there is no case history to learn from about when valuable malls sit on expiring ground leases.

Investors in PCRT (N9LU on the Singapore exchange) are probably quite disappointed now; those who bought at the offering price of 70 cents have seen a 43% decrease in value since June. $336 million of investor value has been lost since the first day of public trading. For those who relied on the independent valuation report, I don't know what legal recourse they have in Singapore.

One bit of encouraging news is that CEO Pua Seck Guan has finally started buying shares at recent market prices. Why didn't he buy before now?

Disclosures: None. I have no short or long position in this stock.
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Wednesday, August 17, 2011

Appraisal in Tepotzotlan, Mexico

The story sounded compelling: 26 hectares of flat, residentially zoned land at the northern periphery of the Mexico City metropolitan area, not far from the Autopista, the major north-south highway leading to Mexico City, 42 kilometers south. Next door was said to be a gated subdivision with a golf course. The owners claimed to have had a bank appraisal in 2006 establishing a value of 177 million pesos, equivalent to about $16 million USD at that time.

The idea of the site’s potential for residential subdivision seemed plausible at first. As modern life takes over Mexico City, it has increasingly grown like an American city, with residents fleeing to growing suburbs and the city population actually declining, similar to Chicago, Detroit or Baltimore. The subject property initially sounded like an ideal location for a new housing subdivision.

The paper chase

One of the documents I requested from the landowner was the most recent predial (property tax receipt). I use it to double-check items such as owner, location, tax ID number (clave catastral), and assessed value, which I hope might point me in the right direction of true market value.

I was provided instead with a predial from 1992, indicating an assessed value of 87,696,000 pesos. Why would they do something like that?

At today’s exchange rate of 12.18 pesos to one dollar, the land would have been worth $7,200,000 back then, but that would be in nuevos pesos, which were not established until 1993, after a period of hyperinflation, when Mexico issued the “new peso” to replace and be valued at 1000 old pesos. The exchange rate on the date of the predial would have been 3064 “old” pesos to one dollar, with the assessed value being equivalent to only $28,621 USD!

Thus, the purpose of providing a predial dated prior to 1993 was an attempt to confuse me. The alleged bank appraisal from 2006 never materialized, either.

The property inspection

After exiting from the Autopista, we traveled another half hour on roads that progressively got narrower and rougher, making numerous turns as we traveled through residential neighborhoods with speed bumps on every block. The paved roads then ended and we traveled on narrow, rutted dirt roads.

Arriving at the site, I found it to be a hillside. The elevation dropped by 150 feet from top to bottom.

Immediately west was a neighborhood of makeshift shacks and dirt roads.
Immediately south was a neighborhood of modest, concrete block structures on small lots, served by paved roads. Graffiti was prevalent.

Immediately north was the countryside. Immediately east was the gated subdivision I had heard about.

Neighboring gated community

After walking about the subject property, we drove to the gated community next door to perhaps give me some idea of the residential development potential of the subject site.

The guardhouse was closed. One of the four gates was open to traffic, however. Once inside, I saw mostly vacant lots, a few structures, some which appeared to be vacant, and no golf course. Census data indicated that only 18 households live in this subdivision. The developer is still advertising to build attractive new 3-bedroom homes of 2500 to 2600 square feet for 1.2 million pesos unfurnished or 1.5 million pesos furnished, equivalent to about $98,000 and $123,000.

Comparable properties

Sales of large parcels were not to be found, so I turned to listings. The most similar property in terms of size and proximity was in the next town west, but its H500A (municipality of Tepotzotlan) zoning allowed 5 times as much residential density as the subject site – 20 dwellings per hectare or 8 dwellings per acre. Its listing price translated to about $72,000 per hectare, for five times the allowable density. Other local parcels were priced as low as $20,000 per hectare (although that one was in a more remote location).

It soon became apparent that the appraised value was going to fall far short of the $16 million that the lender was led to believe. Moreover, this particular lender’s minimum loan size is $1 million with a maximum loan-to-value ratio of 50% for raw land, so there was no real possibility of getting a deal done here.

Sunday, August 7, 2011

Costa Rican Teak Farms for Gringo Investors

I’ve been preparing for an upcoming tree farm appraisal assignment in Costa Rica, but learned late that what was thought to be a teak farm is actually a tree farm with lesser tree species. Nevertheless, something should be said about the teak farm market in Costa Rica.

In the late 1980s Costa Rican President Oscar Arias declared a state of emergency concerning the depletion of the nation’s forests, much of which had been felled for timber harvesting or cattle ranching. Generous tax exemptions were put in place to encourage commercial reforestation projects. Capitalism quickly and enthusiastically addressed the problem, and some of those who observed the flow of international capital into Costa Rican forestry investments figured out that perhaps there was more money to be made by selling forestry investments than in actually growing, harvesting and processing the trees.

As with any market for investment properties, distortions are created when properties are developed in response to investor demand rather than consumer demand. For instance, great surpluses of “rental homes” were developed in Arizona, Las Vegas and Kissimmee, Florida, not in response to a shortage of housing in those areas, but to sell to out-of-state investors. Costa Rican tree farms are now repeating the same concept all over again.

Teak became the preferred tree farm crop because of its high value. There were no restrictions on the creation of new supply in Costa Rica, so many entrepreneurs got into the teak plantation business and European “investment funds” (syndications) were organized to develop teak plantations for small investors, charging high mark-ups. Many teak plantations were subdivided into smaller parcels for purchase by small, absentee investors in North America and Europe.

Misleading data crowding out objective data

The Costa Rican timber market is fragmented and lacking in price information, which has led to the crowding out of objective information by hyperbole crafted by investment promoters, many of who claim historical investment returns in the timber industry of greater than 13% per year. This is not based on Costa Rican data, however.

The most recent price survey among the Costa Rican members of OLAT (the Latin American Teak Organization) indicates prices between $120 and $595 per cubic meter for standing teak trees, depending upon diameter, but prices appear to have decreased since February of this year. For instance, standing teak trees of 50 to 59 centimeters in diameter were priced at an average of $220 per cubic meter then but are now priced at $175 per cubic meter, a drop of 20% in the last six months. Mature trees above 30 years in age have much greater value per cubic meter than immature (“short rotation”) trees, as they can be more efficiently processed into large pieces of sawn wood.

Investment promoters, however, are misleading investors with pro forma cash flow projections based on price increases of 5 to 10% per year, despite the increasing supply of Costa Rican teak, and unrealistically shortened maturity times of 20 to 25 years. OLAT’s data is based on reported prices for mature 30-to-50-year-old trees (the older, the more valuable) and describes 20 to 25-year old plantations as “young plantations” for which there is insufficient market price data, and also commenting that Latin America will supply an important part of the teak market, but is not properly geared to marketing short rotation material. This will change in the coming years, with the knowledge that producers are not getting the best price, the market being controlled by buyers.” In Asia, teak trees are often not harvested until 60 years.

As for the balance between teak supply and demand in Costa Rica, OLAT states “With all the money that was invested by forestry funds over the years in Latin America many plantations were enthusiastically created and the know-how has been improving steadily. Lacking, to some extent, are the sales aspects of plantation products.”

Investment Promoters and Scam Artists
Some investment promoters are not even selling land to investors, just the trees themselves. It is important to know that titled ownership in Costa Rica extends to real estate only; there are no tree titles, and the idea of tree titles in a nation with so many more trees than people would be an administrative nightmare, even if it was tried.  How does one prove ownership of trees that are situated on someone else’s land? Any contract in English is not valid or enforceable in Costa Rican courts, either.

Many investors claim to be victims of scams in which plantation owners sell tree ownership and then charge a fee to manage the tree investment; Tropical American Tree Farms seems to have attracted the most complaints. Most of the alleged fraudsters are gringos themselves, including Eric Heckler, who was a fugitive from mortgage fraud charges in Florida when found selling Costa Rican teak trees that weren't his before being extradited back to the U.S. in 2009.

In the numerous listings of teak plantations for sale in Costa Rica, a sizeable discount per tree is apparent for the larger plantations, indicating an insufficient demand for the quantities of teak they are producing, with prices as low as $167 per standing tree for 20-year-old trees, which translates to about $244 per cubic meter (based on an average of 0.8639 cubic meters per 20-year-old teak tree), or 58 cents per board-foot, quite a bit lower than even the OLAT-published prices.

Next stop: Tepotzotlan, Mexico
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Monday, August 1, 2011

Why Fraud is Attracted to International Real Estate Transactions

Several of my previous blogs refer to the possibility of fraud in international real estate transactions. It stands to reason that a property owner or developer who cannot find buyers or financiers in his own country will seek them out in other countries, perhaps taking advantage of the foreigners' lack of local knowledge. Why, for instance, must Spanish hotels be marketed in the U.S.? Could they not attract European investors?

I do not wish to seem overly critical of Chinese or Central American property owners. A predilection to commit fraud is a fault of human nature and knows no nationality or ethnicity, as I’ve seen plenty of it in the U.S. Fraud tends to flow to those areas where:

1. The controls are weakest,
2. The opacity is greatest,
3. The penalties for fraud are the least severe or least likely to be enforced, and
4. The story sounds the most sensational.

Let me provide an example:

Imagine a nation which has experienced average annual economic growth of 5% after inflation for the last 14 years and real estate prices are rapidly increasing [the story]. Real estate transaction prices are not disclosed due to privacy concerns [opacity]. The culture is very pro-business and real estate regulation is non-existent except for the licensing of real estate sales agents [weak controls]. Prosecution against white collar fraud is unheard of [lack of penalties and enforcement].

Are you ready to invest?

Well, you’re too late, because the place I just described was my home state of Texas in the year 1985. What happened next was an economic disaster. Much of the Texas economic miracle had been based on real estate construction, adding far more supply than could be absorbed at even robust growth levels. Any new development could get 100% financing from a Texas bank, and developers were allowed to order their own valuations from their favorite appraisers. As new buildings stood empty, bank loans could not be repaid. Property prices plummeted. Almost every Texas-domiciled bank and thrift institution failed. Construction workers, realtors, appraisers and bankers lost their livelihoods. The unemployment rate was 12% in Houston when I lost my job there and moved to Los Angeles in 1987.

From 1984 to 1987 I was working in the Houston office of Jones Lang Wootton. My colleagues were busy acquiring and managing investment properties for British, German and Saudi investors who were excited by the Texas story. This all changed rather quickly.

Travel ahead 25 years in time and is China or Costa Rica that much different?

Wednesday, July 27, 2011

The Rights of Foreign Victims of U.S. Real Estate or Mortgage-Backed Securities Scams

A few previous blogs touched on the subject of real estate fraud that crosses national boundaries, and how difficult it can be for American victims to seek redress in foreign courts. I might have sounded xenophobic by focusing on scammers in Latin America, Canada and China, but international real estate fraud works both ways. There are also foreign victims of U.S.-based frauds.

Ethical standards in the U.S. should not be considered different from ethical standards elsewhere. It is not the nationality that matters, but the type of people the real estate industry attracts – people who want to make lots of money. If the real estate industry instead attracted saints, perhaps Mother Theresa herself would have devoted her life to selling condos to foreigners.

Prestige and fame matter little, too, in protection from fraud, as this blog will focus on extensive litigation against Goldman Sachs, an institution once so hallowed that our last three U.S. presidents have selected Goldman executives to become U.S. Secretary of the Treasury, including the present one.

U.S. Securities Laws are not Extra-Territorial

An overseas investor might also be surprised to find that U.S. securities laws do not apply to U.S. real estate investment securities marketed overseas, which includes mortgage-backed securities and real estate syndications.

For instance, Australian hedge fund Basis Yield Alpha recently lost its lawsuit against Goldman Sachs for a $78 million loss on its investment in a Goldman-sponsored CDO (collateralized debt obligation) known as Timberwolf 2007-1, which specialized in subprime mortgage loans. Goldman profited by betting against this CDO, as they have been known to do, even letting John Paulson design another CDO in which he was able to pick the nonprime packages that were “most likely to fail” and then invest in credit default swaps. The U.S. Securities and Exchange Commission sued Goldman and settled for $550 million one year ago this month.

Goldman, for this reason, faces other investor lawsuits from domestic investors, but Judge Barbara Jones dismissed the Australian lawsuit solely because U.S. securities law only governs securities sold within the United States. (As you may recall, This jurisdictional exception was upheld by the U.S. Supreme Court last year in the landmark case, Morrison v. National Australia Bank Ltd. This decision serves to bar the extraterritorial application of the U.S. Securities Exchange Act of 1934. In that case, although the lead plaintiff, Morrison, was American, the remaining plaintiffs were Australian and were victims of NAB’s (National Australia Bank) inaccurate accounting for its American mortgage servicing subsidiary, HomeSide Lending. The plaintiffs argued that the overvaluation of mortgage assets occurred in Florida, where the subsidiary was located, and U.S. securities laws should therefore apply, but the Court found that the securities were sold in Australia, by Australians, to Australians, and therefore U.S. law did not apply. Morrison, the American, could not prove damages, either.

Korean insurer Heunkuk Life Insurance is similarly affected in its lawsuit against Goldman Sachs.

These recent Federal court decisions do not preclude plaintiffs from suing in state courts or foreign courts.

Wednesday, July 20, 2011

GIC's Failed New York Real Estate Investment: An In-Depth Analysis

Stuyvesant Town. 

While recently in Singapore, I encountered lively debate about Singapore’s two sovereign wealth funds, the Government of Singapore Investment Corporation (known as “GIC”) and Temasek Holdings. Given Singapore’s reputation for clean government, some citizens grumbled about the lack of transparency with which these funds operate. I first became curious about GIC last year after learning of their $675 million + loss in the default of a New York apartment community known as Stuyvesant Town/Peter Cooper Village at the beginning of 2010.

The failure of Stuyvesant Town/Peter Cooper Village at the beginning of 2010 resulted in the largest real estate foreclosure [actually “deed in lieu of foreclosure”] in U.S. history. These two aging apartment communities, with a total of 11,250 apartments, were together purchased for $5.4 billion in 2006 in a syndication organized by Tishman Speyer and BlackRock; there was also $4.4 billion in first and mezzanine financing. The purchase price equated to $480,000 per apartment in two complexes that were built in the 1940s, equating to an annual gross rent multiplier of more than 30, unheard of for an American apartment property not headed for condo conversion (but perhaps common in Singapore).

73% of the apartments had rents restricted by New York’s Rent Stabilization Ordinance, and the average rent for a one-bedroom apartment was about $1300 per month at the time. At the time of purchase, market rents on one-bedroom apartments, once renovated, were estimated to be $3200 to $3500 per unit.

The loans were underwritten not according to present income but according to pro forma income expected in 2011, five years hence. Net operating income was forecasted to triple in five years! Tishman reportedly planned to more actively manage the property than previous owner MetLife, and thought rents could be raised through renovation and the eviction of or renegotiation with illegal tenants, estimated to occupy about 1000 units. MetLife previously also had a plan to convert the units into luxury apartments, but found itself legally confounded by tenant litigation. They basically tried the same strategy before and failed.

Enterprising New Yorkers sometimes pretend to keep possession of apartments with restricted rents while subletting to other unrelated parties. Tishman planned to aggressively raise rents on these illegal subletters. One problem, though, was that under the Rent Stabilization Ordinance, stabilized rents below $2000 per month are not eligible to be raised to market value, and most of the units were earning less than $2000 per month.

My personal observation is that New York is a very litigious city (I had an appraisal office there in the 1990s). I have been threatened with lawsuits just for calling up buyers or sellers and asking them what they paid for their properties. MetLife had already been stymied by tenant lawsuits, so Tishman should not have been surprised that its aggressive rental increase program would also attract a class action lawsuit on more than 4000 units. The courts judged $200 million in rental increases to be illegal and awarded $4000 to each renter.

Besides ruinous legal expenses, the financial industry meltdown had hit the New York apartment rental market hard, and market rents were falling. Asking rents on one bedroom apartments at Stuyvesant/Cooper had declined to $2255 per month at the time of foreclosure, not including a $500 move-in bonus.

The first mortgage loan was underwritten at a 1.7 debt coverage ratio based on pro forma Year 2011 NOI, but actual first year debt coverage in year 2006 was only .48! Having worked for America's largest multifamily lender in the 1990s, a deal like this would never have been done. Including the mezzanine debt, the 2011 DCR would have been only 1.2. Even more surprising was that there were two pieces of mezzanine debt, and GIC held the subordinate piece, $575 billion, which became worthless at the time of foreclosure. The superior mezzanine lien at least received $45 million.

What this meant for equity investors was years of red ink before the property could earn positive cash flow. When the projections became unattainable, there was no more reason for the investors to hold on to the properties, and the lenders took possession.

The most recent appraisal of this complex estimated market value at about $2.8 billion, meaning a potential loss of about $2.6 billion for the consortium of lenders which include Wachovia (now Wells Fargo), Merrill Lynch (now Bank of America), GIC and the other mezzanine lender.

Friday, July 8, 2011

The Beijing Gateway Plaza fraud controversy

Almost any real estate valuation report in the world has the same “limiting condition” buried within the report which reads more or less as follows:

We have relied to a very considerable extent on the information provided by the owners and have accepted their representations of tenancy, occupancy, financial performance, site area and floor area, which we assume to be true and accurate. We take no responsibility for inaccurate client-supplied data and subsequent conclusions related to such data.”

What if the property owner lied, though? Then, the accuracy of the valuation is compromised. This is a problem the world over, particularly when the property owner is the one who hired the valuer.

This week’s lawsuit by Tin Lik, a Hong Kong developer, against the trustees of the RREEF China Commercial Trust is an interesting example of the consequences of misrepresentations. This lawsuit came immediately after the June 30th judgment against Tin Lik in the case of HSBC Institutional Trust Services v. Tin Lik, decided by The High Court of the Hong Kong Special Administrative Region.

HSBC Institutional Trust Services was the trustee of the RREEF China Commercial Trust, a Hong Kong REIT having the Beijing Gateway Plaza office complex as its sole asset. On June 4th, 2007 the Trust bought Gateway Plaza from Tin Lik based on Tin Lik’s representations of rental income, representations which were discovered to be false by the newly appointed REIT manager, RREEF China REIT Management Limited, who then calculated the financial value of the discrepancies to be HK$278,526,708. These discrepancies and the estimation of financial loss were later reviewed and confirmed by an independent subcommittee which included an un-named international accounting firm.

On September 7, 2007, Tin Lik agreed to pay the full sum of HK$278,526,708 and promised to make further payments if that sum was later found to be insufficient. Such an action is tantamount to a guilty plea.

A new valuation of the property was done on September 30, 2007, establishing a value of HK$3,699,000,000. After taking into consideration the HK$278 million already paid by Tin Lik, the Net Asset Value attributable to all the unit holders was still HK$69,663,000 lower than if the rents had never been misrepresented.

The Sale and Purchase Agreement by which the Trust acquired Beijing Gateway from Tin Lik established monetary “set-offs” for other discrepancies as well, such as breach of warranties. Tin Lik had warranted certain equipment such as lifts (elevators) and HVAC as being in good repair and reasonable working order, having been regularly and properly maintained and not dangerous or obsolete, but some of the equipment had to be repaired or replaced.

There was also a guarantee of billboard rental income of RMB35 million for the first year, 38 million for the second year, and 40 million for the third year, but the tenant defaulted.

Based on the breach of warranties, the REIT manager calculated further “set-offs” due from Tin Lik as being:

HK $216,890,160 in 2007
HK $ 35,270,591 in 2008
HK $ 11,533,376 in 2009 and
HK $ 12,902,544 in 2010, which adds up to HK$276,596,671 additionally due to the Trust from Tin Lik.

Tin Lik disputed the set-offs and on May 20, 2010, sent a letter demanding repayment of the HK$287,497,000 he paid on September 7, 2007 to settle discrepancies related to rental income. Unfortunately, the property was sold to Mapletree India China Fund on February 3, 2010, and after the sale, a Special Resolution of the unitholders was passed on March 31, 2010 to terminate the Trust and delist it from the Hong Kong Stock Exchange.

Tin Lik is now contending that he was coerced into admitting fraud and making the HK$287,497,000 payment to the Trustees in his new lawsuit, which seeks to recover that payment.
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Monday, July 4, 2011

"Independent Valuation" Problems in Chinese Equity Offerings

One notable scandal this last month was the public accusation that Sino-Forest, a Chinese forestry resources company traded on the Toronto Exchange (TRE.TO), is no more than a Ponzi scheme. The accusation was made by Hong Kong equity research firm Muddy Waters, LLC, in a 40-page research report reminiscent of Harry Markopolos’s expose of the Madoff Ponzi scheme.

I will not comment on the merits of the accusation other than to say that there is enough fraud coming out of China that I don’t see a reason for an analyst to make up false stories. On U.S. exchanges alone, eleven Chinese companies have had their securities registrations revoked by the SEC (Securities and Exchange Commission) and 24 more have been forced to address accounting irregularities or auditor resignations, and of the 19 most recent filings of class action securities lawsuits in the U.S., at least 5 have been against Chinese companies. The simple observation that Sino-Forest has produced no free cash flow or dividends in 16 years in spite of escalating revenues is cause for suspicion. John Paulson dumped his shares right away after the MW report.

Some of you may wonder about the CFE initials in my by-line. They stand for "Certified Fraud Examiner", a credential awarded by the Association of Certified Fraud Examiners. One thing we were taught in our educational program is that fraud is a crime of opportunity. It will move to areas where the controls are weakest, opacity is greatest, and greed and a miraculous story get in the way of due diligence and reason. This makes China an ideal place to commit fraud, just as Florida and Las Vegas were 5 years ago.

Foreign investors are wowed by China's reported 10% annual GDP growth rate and accept Chinese financial reporting with the assumption that auditors and valuers know everything going on within a Chinese company. Many Chinese companies create a labyrinth of offshore entities in the British Virgin Islands and Cayman Islands to hide transactions or owners from view. Sino-Forest and Hui Xian have both done that.

As for Sino-Forest, Muddy Waters specifically addressed the reliability of the "independent valuation" report, as follows:

"TRE provides fraudulent data to Poyry, which
produces reports that do nothing to ensure that TRE is


"TRE became more sophisticated – engaging Jakko Poyry to write valuation reports, all the while giving Poyry manipulated data and restricting its scope of work. Thus more and more investors are drawn into TRE’s fraud every year as it falsifies timber investments and manipulates Poyry further."

One common theme of the Muddy Waters analysis and my own blogs about Perennial China Retail Trust and Hui Xian REIT is the use and abuse of so-called “independent valuation reports” from respected firms with valuers possessing respected credentials. In each case, the sponsors that hired the valuers restricted the scope of work or imposed assignment conditions which impaired the reliability of the reports. Each example is explained as follows:

Independent valuation of Sino-Forest (TRE.TO)

As Muddy Waters describes, the independent valuation firm Jaakko Poyry couched its valuation opinion with multiple disclaimers such as follows:

• “Poyry has not viewed any of the contracts relating to forest land-use rights, cutting rights, or forest asset purchases.”

• “It is important to understand that this is not a confirmation of forest ownership, but rather a verification of the mapped and recorded areas of stocker forest

These types of disclaimers naturally arouse suspicion, as in Shakespeare’s famous phrase, “The lady doth protest too much, methinks.” Why would the valuer feel the need to make such statements unless he knew something was wrong?

Independent valuation of Perennial China Retail Trust (N9LU.SI)

Here’s a situation in which the annual base fee to the Sponsor is established by independent valuation, but the “independent valuer” was asked to assume that all five properties had been acquired and developed and leased to full occupancy, when only one of five properties had been built and two only existed as purchase options. The inflated appraised value of about $1.1 billion SGD is 54% above market capitalization at the close of markets on July 4th. The $1.1 billion SGD appraised value translates to an annual base fee of $3,850,000.

The valuation firm also performed limited due diligence, as they explained as follows in the valuation report that was included in the IPO prospectus:

Whilst CB Richard Ellis has endeavoured to assure the accuracy of the factual information, it has not independently verified all information provided by the Trustee-Manager (primarily copies of leases and financial information with respect to the Properties as well as reports by independent consultants engaged by the Trustee-Manager).

CB Richard Ellis has relied upon property data supplied by the Trustee-Manager which we assume to be true and accurate. CB Richard Ellis takes no responsibility for inaccurate client supplied data and subsequent conclusions related to such data.

This confidential document is for the sole use of persons directly provided with it by CB Richard Ellis (Pte) Ltd. Use by, or reliance upon this document by anyone other than Perennial China Retail Trust Management Pte. Ltd. (as Trustee-Manager of Perennial China Retail Trust) is not authorised by CB Richard Ellis and CB Richard Ellis is not liable for any loss arising from such unauthorised use or reliance. This document should not be reproduced without our prior written authority.”

Independent valuation of Beijing Oriental Plaza (Hui Xian REIT)

The owners had been receiving valuations of its only property, Beijing Oriental Plaza, from DTZ Debenham Tie Leung Limited on an annual basis. The valuation was RMB 11.2 billion at the end of 2009 and RMB 20 billion as of October 31, 2010, based on a decline in market capitalization rates and an increase in rents of 2% for offices and 6.7% for retail tenants.

Nevertheless, for the purposes of the IPO and the estimation of a “revaluation surplus” distribution to the previous owners, a different valuer was chosen – American Appraisal China Limited -- who estimated market value to be RMB31.4 billion as of January 31, 2011, just three months after the DTZ valuation of RMB 20 billion, a further increase in value of 57%. Despite this new valuation, though, the IPO sponsors priced the entire offering at between RMB 26.2 billion and 27.9 billion, 11 to 17% below appraised value. Why would the Sponsors price below appraised value unless they didn’t believe the appraised value of AAC? Why did they switch valuation firms? As of July 5th, market capitalization has dropped to RMB 23.45 billion, which is only 75% of appraised value.

More specific concerns about the valuation report are presented in my Hui Xian blog.

The appraised value of RMB 31.4 billion was used to establish a “revaluation surplus” of RMB 7.775 billion payable to the previous owners, although the market capitalization of the entire REIT was never that high, and current market capitalization suggests that no such surplus value exists. The amount of “revaluation surplus” was based on subtracting net book value of RMB 23.635 billion from the appraised value of RMB 31.41 billion, but current market capitalization of RMB 23.45 billion suggests that no revaluation surplus is warranted, and that the RMB 7.775 billion is money that has been taken from investors through a dishonest scheme.

The new valuers also performed limited due diligence, as they explained as follows:

We have not carried out on-site measurements to verify the areas of the Property and assume the areas contained in the documents provided to us are correct. We have no reason to doubt the truth and accuracy of the information as provided to us by BOP and Commerce and Finance Law Offices on PRC law. We have also been advised by BOP that no material facts have been omitted from the information so supplied. We consider we have been provided with sufficient information to reach an informed view.”


Allowing IPO and subsequent offering sponsors to order “independent valuations” is a blatant conflict of interest, although this is a problem that is not unique to China. Moreover, an "independent valuation" that refuses or is not permitted to perform verification of factual information, such as ownership, financial operations, or property size, is useless and misleading to investors.

Investors should understand that valuers typically put disclaimers and limiting conditions in their valuation reports to prevent liability for passing on fraudulent data. They basically assume that everything the property owner states is true. This does nothing to ensure that valuers rely on accurate data, but deceives investors into thinking that the valuation reports are thorough and accurate.

Disclosure: I do not have any short or long positions in these stocks.

Tuesday, June 28, 2011


Singapore's Marina Bay Sands Casino and Hotel

This website is powered by Google Blogger, and one the most interesting features of Blogger is its tally of the search terms used in finding my International Appraiser blog. My blog on Macau has been attracting those who are searching for statistics on which are the top world gaming destinations by revenue. This particular blog will try to answer that question.

Here is my attempted ranking of world gaming destinations by year 2010 revenues:

1. Macau. $23.543 billion, up 58% from 2009, now exceeding $3 billion/month.
2. Las Vegas/Clark County, Nevada. $7.72 billion (entire county), down 20% since 2006.
3. Singapore. $5.1 billion, first year.
4. Atlantic City. $3.565 billion, down 32% since 2006.
5. Southeastern Connecticut (including Foxwoods, largest U.S. casino). $1.385 billion, up 12% from 2009.
6. Biloxi, Mississippi. $1.106 billion, down 15% since 2007.

This list focuses on singular destinations with an agglomeration of casinos in close proximity rather than countries or states where casinos are geographically dispersed such as France, Pennsylvania, Indiana or the Dominican Republic.

The one trend that is obvious from this list is the explosive increase in gaming in Asia and the decline in gaming in the leading U.S. destinations.

The U.S. gaming market has become increasingly fragmented, with Indian casinos in California and Nevada taking customers away from Nevada’s traditional gaming destinations of Las Vegas, Reno and Laughlin, and Pennsylvania and New York taking customers away from Atlantic City. There are now 19 U.S. states that allow casino gambling, and increasing state budget pressures may tempt more to legalize casino gambling in order to augment revenue.

One important difference in making comparisons between Las Vegas and Asia is that Las Vegas earns more from lodging, food and beverages than from gaming revenues, as most visitors to Las Vegas need to stay overnight because of its distance and isolation from the places the visitors come from; long haul visitors stay longer than short haul visitors, and Las Vegas attracts more long haul visitors. For instance, although the Las Vegas Strip earned $5.167 billion in gaming revenues last year, it also earned $3.106 billion in lodging revenues and $2.923 billion in food and beverage revenues. On the other hand, many visitors to Macau and Atlantic City are on day trips from Hong Kong or Guandong Province (in the case of Macau) and New York or Philadelphia (in the case of Atlantic City).

2017 update:
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